Costs of Quality: Measurement,

Reporting and Control

Importance of Quality
Costs of Quality
Measuring Quality Costs
Methods to identify Quality Problems
Reporting Quality Costs
Relevant Costs and Benefits of Quality
Improvement
 Importance of Quality

Quality as a competitive tool

(improving quality can improve their
financial and competitive position)
Research has shown that there is a
positive correlation between quality
and firm value
 Importance of Quality

Quality improvement can increase

firm value because it increases a
firm’s profitability by:
– Increasing customer demand
– Decreasing the cost of providing
goods and services
Close association between quality
and customer satisfaction
 Meaning of Quality (cont.)
Two basic aspects of Quality
– Quality of design (how closely the
characteristics of a product or services
meet the needs and wants of
customers)
– Conformance quality (performance of
product or service relative to its design
and product specifications
Conformance is strongly emphasized
because it is the key to meet customer
expectations
 Meaning of Quality
Meaning of Quality
– Quality as the degree or grade of
excellence
– A quality product or service is one that
meets or exceeds customer
expectations on the key attributes of
product performance, reliability,
durability and fitness for use
 Cost of Quality
Costs of quality are the price of non
conformances
The optimal level of the cost of quality
should be about 2 to 4 percent of sales
The difference between actual and
optimal levels represents a rich
opportunity of improving quality, thus
improving profitability
 Cost of Quality
Costs of quality are the costs that exist
because poor quality may or does
exist.
Refers to costs incurred to prevent or
the costs arising as a result of
producing a low-quality product
 Cost of Quality (cont.)
Quality costs are associated with 2
sub categories of quality related
activities:
– Control activities
– Failure activities
 Control activities/costs
Control costs are the costs of
performing control activities.
 Control activities
• Control activities are made
up of:
prevention activities
appraisal activities
 Costs of Quality

Four categories of quality costs:

– Prevention costs (costs incurred to preclude
the production of products that do not conform
to specifications)
Examples: Quality engineering, quality training
training programs, quality planning, quality
reporting, supplier evaluation and selection, quality
audits, quality circles, field trials and design reviews
As prevention cost increase , the costs of failure
are expected to decrease
 Appraisal Costs
 Costs incurred to detect which of the individual units of
products do not conform to specifications)
 Main objective of appraisal function is to prevent
nonconforming goods from being shipped to customers
 Incurred to determine whether products and services
are conforming to their requirements or customer needs
 Examples: inspecting and testing materials, packaging
inspection, supervising appraisal activities, product
acceptance, process acceptance, measurement
(inspection and test) equipment and outside
endorsements
 Failure activities (cont.)
– Failure activities are made of:
internal activities
external activities
 Failure Activities/Costs
Failure activities refer to those activities
performed by an organisation or its
customers in response to poor quality

Failure costs are the cost incurred by an

organisation because failure activities are
performed
 Internal failure costs
Costs incurred on a defective product
before it is shipped to customers)
Incurred because products and
services do not conform to
specifications or customer needs
Detected prior to being shipped to
outside parties
 Internal failure costs
Internal failure costs
– Internal failures are those that can be
detected by appraisal activities
– Examples: scrap, rework, downtime
(due to defects), re-inspection,
retesting and design changes
 External failure costs
Costs incurred on a defective product after it is shipped
to customers)
Incurred because products and services fail to
conform to requirements or satisfy customer
needs after being delivered to customers
The most expensive type of quality costs
Examples: costs of recalls, lost sales because
of poor product performance, returns and
allowances because of poor quality, warranties,
repair, product liability, customer
dissatisfaction, lost market share
Prevention costs Appraisal costs
Systems development Test and inspection of
Quality engineering incoming materials and in-
Quality training process goods
Quality circles Final product testing and
inspection
SPC activities Supplies used in testing and
Supervision of prevention inspection activities
activities Depreciation and
Quality improvement maintenance of test
projects equipment
Audit of the effectiveness Field testing and appraisal
of the quality system at customer site
Quality data gathering, Plant utilities in the
analysis and reporting inspection area
Technical support provided
to suppliers
Internal failure External failure
Net cost of scrap and Cost of field servicing and
spoilage handling complaints
Rework labour and Warranty repairs and
overhead replacement
Reinspection and Product Recalls
retesting of reworked
products Liability arising from
defective products
Disposal of defective
goods Returns and allowance
arising from quality products
Downtime caused by
quality problems Lost of sales arising from a
reputation for poor quality
 Measuring Quality Costs
Quality costs may be classified as:
– Observable
(quality costs available from an
organisation accounting records)
– Hidden
(opportunity costs resulting from poor
quality)
Usually in the external failure category
 Measuring costs of quality
Multiplier method
– Assumes that total failure cost is some
multiple of measured failure costs
– Formula:
Total failure costs= k (Measured external
failure costs)
K = multiplier effect whose value depends on
experience
 Measuring Quality Costs
Market Research Method
– Uses formal market research methods to
assess the effect of poor quality on sales and
market share
– Customer surveys and interviews with members
of a firm’s sales force would provide insights into
the magnitude of the firm’s hidden quality costs
– May use to project future profit losses
attributable to poor quality
 Measuring Quality Costs
The Taguchi Quality loss Function
– Assumes that any variation from the target value
of a quality characteristic causes hidden quality
costs
– The hidden quality costs increase quardratically
as the actual value deviates from the target value
as follows:
 The Taguchi Quality loss Function
(cont.)
L(y) = k (y –T)2
Where y = actual value of quality
characteristic
T = Target value of quality characteristic
L = Quality loss
K = proportionality constant dependent on
the organisation’s external failure cost
structure that can be estimated as follows:
K = c/d 2
The Taguchi Quality loss Function
(cont.)

Where c = Loss at the lower or upper

specification limit
d = distance of the limit from t
(the target value)
Total hidden quality costs
= L (y) x Number of units produced
 The Taguchi Quality loss Function (cont.)
Example:
ABC Sdn Bhd makes components for inclusion in
electronic testing equipment. Component 5A has
a target value of 500 grams. Specifications limits
are minus or plus 10 grams. ABC’s industrial
engineers have determined that losses at the
lower specification limit equal RM300. A sample
of 5 units yielded the following:
Sample Actual weight
1 495 grams
2 503
3 511
4 487
5 499
 The Taguchi Quality loss Function
(cont.)

Calculate the loss for each unit and average

loss for the sample of 5.
k = c/d2
= 300/102
= RM3 per unit
Sample Actual wt (y) Y -T (y-T)2 K(y-T)2

1 495 -5 25 RM75
2 503 3 9 RM27
3 511 11 121 RM363
4 487 -13 169 RM507
5 499 -1 1 RM3
325 RM975

Average 65 195

Total hidden quality cost = 195 x 2,500 = RM487,500

Methods to identify Quality problems
Control charts
– Also known as statistical process control (SPC)
- A control chart is a graph of a series of
successive observations of a particular
step/procedure/operation taken at a regular
intervals of time
– Formal means of distinguishing between
random and nonrandom variations in an
operating process
Methods to identify Quality problems

– Random variations : power surges or chance

fluctuation in temperature cause defective
products to be produced in a chemical process
– Nonrandom variation occur when defective
products are produced as a result of a
systematic problem such as inaccurate
temperature readings
Methods to identify Quality problems
(cont.)
Pareto diagrams
– A chart that indicates how frequently each type
of defect occurs, ordered from the most
frequent to the least frequent
– Helps the TQM team visualize and
communicate to others what the most serious
types of defects are. Steps can be taken to
tackle the most serious and most frequent
problems first
Methods to identify Quality problems
Cause and Effect diagrams
– Identifies potential causes of defects
– Can be used to analyse the most frequently
recurring and costly problems
– Also known as fishbone /Ishikawa diagrams
– Example: refer to Ishikawa diagram used by
Xerox Corp. to identify the causes of errors in
its billing process
– Identification of possible causes helps the
management to take systematic steps to
eliminate the root causes of the errors
 External customers
Billing system

Communication
Cumbersome

Reading an
System errors invoice
Billing meters
Input requirement

Pricing Current price

actions information

Employee driven Timeliness

Ownership
Ownership

Awareness

Awareness
Training/Education

Training/Education
Communication

Communication

Out of district
personnel District personnel
Cause and effect diagram: Billing quality at Xerox Corporation
 Reporting Quality Costs
To create a quality cost reporting system, need to
assess current actual quality costs
A detail listing of actual quality costs by category
can provide 2 important insights:
– Reveals the magnitude of the quality costs in each
category , allowing managers to assess their
financial impact
– Shows the distribution of quality costs by a category
allowing the managers to assess the relative
importance of each category
 Reporting Quality Costs (cont.)
Quality Cost Reports
– Express the quality costs as a
percentage(%) of actual sales in order to
assess the financial significance of quality
costs
– Illustration of a Quality Cost Report
 ABC Sdn Bhd
Quality Cost Report
For the year ended June 30, 2003

Costs Quality Costs Percentage of Sales

Prevention costs:
Quality training 10,000
Reliability engineering 65,000 75,000 1.5%

Appraisal costs:
Material inspection 5,000
Product acceptance 20,000
Process acceptance 75,000 100,000 2.00%

Internal failure costs:

Scrap 150,000
Rework 100,000 250,000 5.00%

External failure costs: 150,000

Customer complaints 250,000
Warranty 175,000 575,000 11.50%
Returns and allowances

Total quality costs 1,000,000 20.00%

Types of Quality Performance Report
Interim standard report
Measures and reports the progress
achieve by the firm with respect to a
current period std or goal
Compares the actual quality costs for
the period with the budgeted costs
Types of Quality Performance Report
(cont.)
Multiple Period Trend report
Multi period report which tracks the
progress trend since the inception of
the quality improvement program as
follows:
– The change in total quality costs as a
percentage of sales over time
– The change of the relative distribution of
quality costs as a percentage of sales
over time
 Types of Quality Performance
Report (cont.)
Long range report
– The long range report which tracks progress
with respect to long range standard or goal
of zero defects
– Compares the current period’s actual costs
with the target costs and identifies the
variances
Target costs are the costs that would be allowed
if the zero-defects standard were met. The target
costs are the non value added costs
The variances are nonvalue added costs
Incentives for Quality Improvement

Should provide both monetary and non-

monetary recognition for significant
contributions to quality improvement as
follows:
Non monetary incentives such as non-
financial awards and public recognition for
outstanding performance are useful because
they create greater employee job satisfaction
and further commitment to quality
Incentives for Quality Improvement (cont.)

Non-monetary incentives also allows management

to underscore its commitment to quality improvement
Participation helps employees internalize quality
improvement goals as their own through the following
program:
– Error cause identification (a program in which employees
describe the problems that prevent them from doing their
jobs right for the first time)
– Error cause removal approach encourages employees to
submit quality improvement suggestions. An employee
submitting an entry will receive a note of appreciation from
management.
Incentives for Quality Improvement (cont.)
Monetary incentives
– Gainsharing provides cash incentives for
the entire workforce that are keyed to
quality or productivity gains
– The incentive bonuses might be equal to a
percentage of the cost savings
– Gainsharing are entirely complementary to
an integrated measurement system such
as Balanced Scorecard